Fitch Ratings has stated that smaller, fast-growing banks could be underestimating the impact of a potential downturn when calculating their risk management due to their short track record and lack of historical data.
According to the agency, several challenger banks have grown faster than the market in "relatively benign conditions" and their performance has not yet been tested in a downturn environment.
An above-market-average growth is seen as a potential risk to a bank’s credit profile, according to Fitch, as the growth could be due to the under-pricing of risk or a loosening of underwriting standards to create volume.
Challenger banks have grown fast in niche mortgage lending recently, often lending on subprime or second charge products which naturally hold higher risk.
A similar sentiment was expressed by the Bank of England earlier this month when in a Dear CEO letter the bank said it had found that many new lenders were "overly optimistic" about the impact a stress scenario would have on their business.
The bank also told fast-growing lenders that they may be underestimating their potential losses in a stress scenario and overestimating their ability to gain capital in the context of a financial crash.
Fitch noted that in general UK banks’ loan books were performing well and that most mortgage loans were providing banks with the expected revenue, but stressed this was after a decade of low interest rates, low unemployment and until recently, strong property price growth.
The agency said some challenger banks should be setting aside more capital to protect themselves against any rise in interest rates or spikes in unemployment which could increase losses on their mortgage portfolio.
On top of this, falling house prices could exacerbate the impact, particularly for banks that have more high loan-to-value mortgages in their book, it stated.
Nationwide's latest House Price Index showed the UK’s annual house price growth remained below 1 per cent for the seventh consecutive month in June as prices continued to fall in outer London, the capital itself, and the south east region.
Fitch placed all rated UK banks on "rating watch negative" — a status given to companies while the agency decides whether to lower their credit rating — earlier this year as uncertainty over the Brexit process and the risk of no-deal increased.
Banks with less diverse loan books or those focused on niche sectors, a category which many challenger banks fall into, are more vulnerable, Fitch stated.
Shaun Church, director of Private Finance, thought it was "definitely true" that smaller banks would struggle more significantly in any economic downturn.
He said: "It just goes to show that the memory of what happened pre-crash and the likes of Northern Rock are still there with people.
"That’s something smaller challenger banks are going to have to work hard at to overcome."
But Mr Church thought clients of such banks were not at a risk as the issue was primarily for the lenders themselves rather than the consumer.
He added: "The worst thing to happen would be the unintended consequence that your mortgage gets sold on, but I don’t think borrowers are at any further risk because they owe the bank money, not the other way round.
"It’s more of an issue for savings. If you’re looking at smaller banks for savings, I would tread more carefully."
Mr Church added that all banks — big or small — were likely to suffer if it got to the point of a financial crisis.
imogen.tew@ft.com
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